Friday, February 22, 2013

Fact #1 – LINN is confident in the validity and accuracy of its audited financial statements.

Drolly I note that for 2012, the company reported net loss of $387 million, or $1.92 per unit. For the quarter the loss was $187 million. (Source here.) Obviously a good part of this loss was write-downs from writing off oil and gas properties that became less valuable as gas prices fell.

However there should be an offsetting write-up in the value of the hedges so that defense will get only so far.

Whatever: unusually for a stock I write about in Linn's case I (mostly) believe in the validity of the accounts. The accounts say quite bluntly that

(a). This is a loss making enterprise.
(b). That this business pays out large and increasing distributions despite those losses and
(c). The business raises ever increasing amounts of funds using ever-more-novel ways of doing it.

To me that looked like a Ponzi scheme on its last legs. Indeed to come to a different conclusion I thought you had to accept some non-standard non-GAAP measures as reality. In other words you have to ignore the audited bottom line for the company.

Many people it seems do ignore the bottom line. They are encouraged by the management - and they might be right - but for the moment I have (and retain) a different opinion.

But I was wrong

Despite not changing my opinion on the fundamentals of Linn I will confess to being wrong on one important (nay critical) point.

When Linn launched Linco (their non-MLP associate which exists only to hold interests in Linn) I thought the money-raising was on its last legs. Specifically I thought that rather than target the non-sophisticated mom-and-pop investors who buy MLPs they were being forced to target more sophisticated investors as they had run the non-sophisticates out of money.

I did not see it coming. It was not even on my original list of risks in the position. Wrong!

This is a great deal for Linn. They get to swap what I believe to be near-worthless stock for some old - but still valuable oil assets. Those assets will generate cash - cash that can keep this whole thing rolling along for a few more years.

So even if I am right that Linn is a Ponzi (and many company supporters disagree with me) it is not a Ponzi that will collapse next week. And so my opportunity to profit will not be next week.

I covered most of my short.

For a loss.

John

PS. The company now has some time to prove that it is not a Ponzi. Substantial GAAP profits might be a start - but hey - ten more years of distributions would also be effective.

Thursday, February 21, 2013

A fairly standard oil-and-gas valuation metric is the price per flowing barrel for oil and gas.

Oil at $100,000 per daily flowing barrel is considered high end - but some transactions happen at higher prices when there are further development opportunities in the field and the oil is light, sweet crude.

Flowing gas (per BTU) is typically worth about half flowing oil. [Use a conversion that 6 Mcf of gas is equivalent to about 1 barrel of oil]. So lets call this $50,000 per flowing barrel equivalent.

Natural gas liquids trade at about half the price of oil - and so a flowing barrel should be worth about half a flowing barrel of oil. Also lets call this $50,000 per flowing barrel equivalent.

These are fairly standard metrics and any oil and gas analyst should be able to confirm that I am not rigging the numbers here.

Linn Energy per flowing barrel

Here - from the last form 10-Q is the average daily production of Linn Energy for the last quarter by different types of hydrocarbon:

Three Months EndedSeptember 30,

2012

2011

Variance

Average daily production:

Natural gas (MMcf/d)

409

170

141

%

Oil (MBbls/d)

30.8

22.6

36

%

NGL (MBbls/d)

31.4

12.2

157

%

Total (MMcfe/d)

782

379

106

%

The increase is not driven by field development but by buying almost $2.5 billion in new assets.

Using the metrics above:

The gas production is worth 409,000*$50,000/6 = $3.41 billion.

The oil production is worth 30,800*$100,000 = 3.08 billion and

The NGL production is worth 31,400*$50,000= 1.59 billion

The total valuation of the hydrocarbons is thus 8.08 billion as per the flows in the last 10-Q.

The last 10-Q also showed LINN as having debt of $6.84 billion in debt. So the equity would be worth 1.24 billion.

There were 199 million units outstanding as per the last 10Q. This gives an equity valuation of $6.22 per unit - a fair bit lower than the current price of $36.65 per unit. Longs can expect an 80 percent loss on their units using these valuations.

My view is that Linn Energy's gas and oil fields are pretty clapped out - and worth considerably less than the above metrics. The average well flows about 6 barrels per day! [My personal view: the debt will be impaired.]

However even at a full price this MLP is worth under $7 per unit.

To be fair though - this company has purchased a lot of in-the-money options and its option position is valuable. The value of those is about $900 million - which is almost $4 more per unit.

To get anything like the price targets of the bullish analysts are putting on it you need to think these clapped out assets are worth $200,000 per flowing barrel.

I know, I know you object: MLPs are not valued on their underlying assets. They are valued on their yield.

Wednesday, February 20, 2013

The last post explained just how bizarre the definition of EBITDA/distributable cash is at Linn Energy. This bizarre definition of EBITDA in my opinion allows a zany and unsustainable level of distributions to be paid and hence attracts investors.

This stock is sold on the yield.

I think you should buy shares on the underlying assets and not a running yield.

So it is worth looking at what the underlying assets are.

Here from the last 10-K is a disclosure on the number of productive wells owned:

Productive Wells

The following sets forth information relating to the productive wells in which the Company owned a working interest as of December 31, 2011. Productive wells consist of producing wells and wells capable of production, including wells awaiting pipeline or other connections to commence deliveries. “Gross” wells refers to the total number of producing wells in which the Company has an interest, and “net” wells refers to the sum of its fractional working interests owned in gross wells. The number of wells below does not include approximately 2,500 productive wells in which the Company owns a royalty interest only.

Natural Gas Wells

Oil Wells

Total Wells

Gross

Net

Gross

Net

Gross

Net

Operated (1)

3,889

2,925

3,870

3,578

7,759

6,503

Nonoperated (2)

1,843

369

1,628

207

3,471

576

5,732

3,294

5,498

3,785

11,230

7,079

(1)

The Company had 12 operated wells with multiple completions at December 31, 2011.

(2)

The Company had no nonoperated wells with multiple completions at December 31, 2011.

The previous year the total was not dramatically different - this from the 10-K for the year ended 2010:

Productive Wells

The following table sets forth information relating to the productive wells in which the Company owned a working interest as of December 31, 2010. Productive wells consist of producing wells and wells capable of production, including wells awaiting pipeline or other connections to commence deliveries. “Gross” wells refers to the total number of producing wells in which the Company has an interest, and “net” wells refers to the sum of its fractional working interests owned in gross wells. The number of wells below does not include approximately 2,700 productive wells in which the Company owns a royalty interest only.

Natural Gas Wells

Oil Wells

Total Wells

Gross

Net

Gross

Net

Gross

Net

Operated (1)

3,751

2,707

3,346

3,088

7,097

5,795

Nonoperated (2)

1,717

342

1,572

175

3,289

517

5,468

3,049

4,918

3,263

10,386

6,312

(1)

Ten operated wells had multiple completions at December 31, 2010.

(2)

Three nonoperated wells had multiple completions at December 31, 2010.

They would have averaged about 3,170 net productive gas wells and 3,520 net productive oil wells. The average total productive wells would have averaged about 6,700.

And here from the form 10-K is the average daily production.

The following sets forth information regarding average daily production, average prices and average costs for each of the periods indicated:

Year Ended December 31,

2011

2010

2009

Average daily production:

Natural gas (MMcf/d)

175

137

125

Oil (MBbls/d)

21.5

13.1

9.0

NGL (MBbls/d)

10.8

8.3

6.5

Total (MMcfe/d)

369

265

218

They produced 175,000 Mcf/d of natural gas and 21,500 barrels of oil per day with another 10,800 barrels of natural gas liquids.

The total gas equivalent is 369,000 Mcf/d of natural gas.

Lets do some division. The oil wells produce 21,500 barrels of oil per day from an average of 3,520 wells. This is an average of 6 barrels per day.

There are going to be an awful lot of wells that produce less than two barrels per day.

The gas wells produce 175,000 Mcf/d of natural gas from 3,170 wells. This works out at 55 Mcf/d in gas. At a $3 gas price these wells are producing - get this - $165 in natural gas per day. Presumably these wells are also declining...

Fortunately they also produce 10,800 barrels of natural gas liquids per day. That is 3.4 barrels of liquids (at about $45 a barrel as an estimate).

I have a few questions of management:

Question 1

How many of the much-vaunted wells produce less than $100 gross revenue per day? Oh, that $100 needs to be before hedging!

Question 2

How many wells were shut down or went out of production in each of the last five years because the flow rates were so low the wells became non-economic?

Question 3

What is the right level of maintenance capital expenditure for wells with flow rates this low? How does this level of maintenance capital expenditure differ from the maintenance capital expenditure used for calculating distributable amounts?

High valuations for clapped-out assets

This company sports a premium valuation for very old and very run-down-low-production wells.

I believe this premium valuation is because people see the (high and attractive) dividends not the (clapped-out) underlying assets.

The fact that the dividends are - at least in part produced by financial engineering not cash flow (as per the last post) is besides the point. This company buys and manages clapped out oil and gas properties and maintains a perception of asset backing. After all the MLP is issuing large numbers of units and they are selling both dividends and the perception of asset backing. Telling a good story about run-down assets is necessary.

The long term future of Linn Energy: Who would normally own the wells?

These wells are valuable. A well flowing 3 barrels per day still generates $70-100 thousand a year of gross revenue. There is only a small fraction of that left after production taxes and maintenance. Someone has to fuel and maintain the nodding-donkey oil pump after all. And someone has to drive the truck around to collect the oil.

This is gritty work. Apart from anything these fields are laden with environmental problems - because typically the pump is pulling up a barrel of oil and fifty barrels of salt water per day. The salt water needs to be disposed of. And the oil collected and spills dealt with.

So you are under no illusions this what a typical unit producing one barrel per day (and 150 barrels of salt water) looks like check out this video from You Tube.

What you own if you own Linn Energy is simple. It is thousands of these things.

But lets get back to the natural owner of this well. I know the guy. Sun burnt but would be far more sun burnt without the hat. A pick-up truck. Dog and a shot-gun in the back. Political views well to the right of mine.

You have to admire this guy - he is a self-reliant individual who works without much corporate overhead. Has nobody to blame when the electric motor burns out than himself. And he works hard. Real hard.*

This assets owned by Linn Energy are not normally the sort of asset owned by a 14 billion dollar enterprise valuation listed entity. They are owned by the red-necked, gun-toting self-reliant individual who works hard and does not mind getting his hands dirty.

When this MLP runs out of cash to distribute it is likely to be dismantled and the assets will be sold to those those fine people with their politics, dogs and shotguns. Assets like these tend to find their natural owners.

In liquidation I seriously doubt if there will be anything like enough to make whole the $7 billion owned to the banks and other lenders. If you are Linn Energy debt-holder beware.

Something substantial for the residual equity holders? Surely you must be joking?

John

*Please understand I am not mocking the natural owner here. If my (non-existent) daughter married him I would be pleased for her even if social conversation at Christmas dinner was awkward. I have far more respect for that-type than I have for many financial or CEO types...

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.